Savings and Investing Buckets

Bucket 1 – In Case of Emergencies… Cash

Although focusing on investing is how you will grow your nest egg, all of us will encounter times when we need cash quickly. From auto repairs to medical bills, you should have cash on hand to fund not just monthly expenses but also the unexpected. A general rule of thumb is that individuals should have somewhere between three (if single) to six (if married) months of monthly expenses on hand in a cash savings account.

It may be difficult to make peace with your cash bucket earning very little. However, the bucket should be considered and viewed more as insurance against unforeseen life events and a hedge against having to take losses in your investments in the case of emergencies (a forced sale from an investment portfolio can have detrimental long-term impacts, especially when conducted during a down market). Luckily, in today’s relatively higher interest rate environment, there are bank savings options that carry interest payments in the range of 3% to 4%.

Bucket 2 – Free Money? – Employer-Sponsored Retirement Plan

Employers typically sponsor retirement plans such as 401ks with a matching employer contribution amount. If you also contribute, the matching employer contribution is essentially free money from your employer. It would be unwise not to participate and leave the funds on the table. The rule of thumb is that the minimum amount of contributions you should put into an employer-sponsored retirement plan is up to the employer’s matching contribution. For example, if the employer matches 5% of your salary, you should, at minimum, also contribute 5% of your salary to qualify for the match.

Nowadays, most employers offer a traditional pre-tax option along with a post-tax Roth option within their sponsored plans. In a pre-tax 401k, for example, you contribute untaxed funds into your account. The assets then grow tax-deferred until you withdraw them, at which point the funds would be taxed as ordinary income. A major advantage of making pre-tax contributions is the corresponding tax deduction you receive on today’s income tax return. This is very appropriate for high-income earners who expect their income tax brackets to lower in the future. On the other hand, in an after-tax Roth 401k, you pay income taxes today and contribute net funds into your account. As in the traditional 401k, the assets similarly grow tax-deferred. However, unlike the traditional 401k, which will be taxed later, the Roth 401k funds will be withdrawn tax-free in the future. This is a major advantage of the Roth 401k option, especially for younger earners who are in a relatively lower-income tax bracket currently.

Due to higher contribution limits and greater asset protection laws surrounding qualified employer-sponsored plans, these are generally preferable to IRAs during working years (discussed below).

Bucket 3 – Alternative to Employer-Sponsored Plans – IRAs

If your employer does not offer a retirement plan, you should consider IRAs. IRAs are yours, and yours alone, and you can contribute to an IRA, subject to IRS income limitations if you earn income. As with employer-sponsored plans, there are traditional pre-tax and Roth IRAs; you can use both, subject to IRS income limitations. There are many pros and cons when comparing employee-sponsored retirement plans versus IRAs. A major advantage of IRAs is that you are offered far broader investment choices than in a typical employer-sponsored plan. A major disadvantage, on the other hand, is that the contribution limits for IRAs are considerably lower than the contribution limits for employer-sponsored plans.

SEP IRA is available to self-employed or small-business owners with no employees. The account allows you to stockpile nearly 10x the contribution amount of traditional IRAs.

Bucket 4 – Cash and Retirement Accounts Alone are Insufficient – Investment Accounts

There are several risks if you stop your overall financial plan at cash and retirement savings only. Among them are:

• Holding cash above your emergency needs is a risk because of inflation. The value of your savings is reduced as prices rise over time.

• Having all your eggs in your retirement plan bucket is a risk (assuming these are non-Roth accounts) due to taxation in the future, especially when you are required to take Required Minimum Distributions upon attaining age 73 (or age 75 beginning in 2033). If a retirement account is your only source of income, withdrawals may be a double hardship as it requires additional withdrawals to account for taxes, which in effect, may increase your Medicare premium costs in the future.

Once you’ve fully funded your emergency cash bucket and begun a savings regimen in your retirement account, you should next establish a taxable investment, or brokerage, account to round out your financial picture. There are several important advantages associated with brokerage accounts:

• Since you fund brokerage accounts with funds that have already been taxed, future taxes on any withdrawals above basis (the basis is the amount you originally contributed) will be taxed at more favorable capital gains tax rates. Withdrawals of basis are never taxed.

• If you want to buy a home, take a trip, or make a large purchase, the money in a taxable account can be readily accessed. While most withdrawals from retirement accounts cannot occur before attaining age 59.5, you can always tap into your brokerage account.

• There are advantages to your heirs, as they would receive a “step-up” in basis upon your death. Step-up is a beneficial estate planning tool.

Closing Remarks

An emergency cash account, retirement plans, and brokerage accounts work in tandem to ensure you have the optimal mix of vehicles to grow your nest egg. A successful financial plan is a balancing act and depends on funding all buckets effectively.

Our team has experience in helping clients navigate and structure the most appropriate plan that will ultimately help them achieve their financial goals. We are happy to assist you!

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